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Hi! I was going through the notes and I came across this problem in Chapter 5: Auditor’s Report:
As a general Rule of thumb, Materiality is calculated as:
>0.5% to 1% of Revenue,
>1% to 2% of Total Assets, or
>5% to 10% of ProfitWhy is it 0.5-1 for revenue and not for total assets. Usually, Total assets are a greater number compared to revenue, shouldn’t the % for Revenue be greater than Total Assets?
These are just guidelines – it is for the auditor to decide for each audit what is material. In a service business, for example, there may be very little investment in PPE/working capital so revenue/profit would be more relevant. If there is a loss, a % of profit wouldn’t be relevant.
Say you are looking at a set of financial statements:
1/2 – 1% revenue is $175 – 350k
1 – 2% total assets is $750 – 1,500k
5 – 10% profit is $290 – $580kSuppose the audit identified cut-off errors in sales amounting to $200k (overstatement of revenue and hence profit and overstatement of receivables) – that is material only to revenue – and the auditor would mostly want to see an adjustment.
Suppose the audit identified an overstatement of inventory of $250k – that doesn’t even affect revenue – total assets and profit are both overstated – but not materially. So even if no adjustment is made for this the auditor would concluded that the financial statements are not materially misstated.
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